Listen to Buffett and Schwab: Be an indexer

Keeping it easy, cheap and simple

Chuck Schwab, founder of Charles Schwab & Co.
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, talked last week about the power and importance of indexing, suggesting that low-cost diversified funds that track indexes are the best approach for 95% to 98% of Americans.

A few months ago, one of the few investment icons actually bigger than Schwab, Warren Buffett, revealed that if his wife survives him, his estate plan will recommend keeping 90% of her inheritance in the Vanguard Index 500 fund
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, with the rest in short-term government bonds.

For investors who want to follow the leaders here, picking straightforward index ETFs and funds means finding the ones with the lowest costs and putting money to work.

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But the spin has already started, suggesting that the indexing strategy can be tailored into something better.

Indeed, the evolution of exchange-traded funds — built mostly like index funds but traded like stocks — has made it so that investors have tremendous choice and opportunity.

With those choices, however, come some problems, because while a legend like Schwab can come out and recommend indexing for average Americans, he’s not suggesting mucking up the strategy.

Look at any chart of the big, brand-name indexes — the S&P
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, the Russell 1000
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, and moving on out to total-market options — and the construction of the index doesn’t seem to make much difference. You can basically lay the performance charts on top of each other and the differences are minute.

At that level — precisely what Schwab and Buffett were discussing — simple and low-cost wins; you’re strapping yourself to the market (or a big chunk of it), planning to ride the long-term trend.

“The more refined your indexing strategy gets — going from broad market segments to sectors or countries or industries — the more wary you have to be of what it is you are buying,” said Dan Wiener, chief executive officer at Adviser Investment Management in Newton, Mass., and the editor of The Independent Adviser for Vanguard Investors. “These indexes have been created out of thin air to provide a product that somehow differentiates itself from others, and you want to know where the index came from, what goes into it, how long has it been around, how often has it changed, will the provider be around in three years if the ETF doesn’t draw a lot of assets and more.

“You change what you are trying to do with ETFs and you change how easy or hard they are to pick for your portfolio,” Wiener said.

David Trainer, president of New Constructs, a Nashville-based research firm, has said on my radio show that there are 45 financial-sector ETFs, and that some hold as few as 20 securities while others have over 500. If you choose a broader style — like large-cap value ETFs — there are about 50 options, and while the tightest portfolios still start in the 20s, the most-diversified options hold 1,400 securities.

Investors who have embraced indexing — including Buffett and Schwab — are recognizing the folly in active management, the potential to let emotions and nerves interrupt a long-term strategy at just the wrong time.

They’re not advocating for actively managing passive investments, where an investor or their adviser believes that indexing is the better way to invest, but then trades in and out of those benchmark issues. That just shifts active management from the fund level — where numbers show the traditional fund manager has trouble keeping up — to the portfolio level, where the trading activity is run outside of the funds, but the overall returns are still diminished by the action.

“Buying a sector ETF without analyzing its holdings is like buying a stock without looking at the balance sheet,” Trainer said.

That’s important to remember as Schwab’s statement from this week is chopped into increasingly smaller sound bites, and loses most of its context.

Schwab was endorsing indexing for investors who are still nervous about the market, who fled the market during or after the financial crisis of 2008 and need a strategy to build savings for a lifetime.

“We need to get the word out because people now coming back in the market here in 2014, some who got out in 2008, 2009 — what’s an easy way for them to get in? What’s a cheap way to get in?” Schwab said during a conference call with reporters.

Easy and cheap means keeping it simple, not necessarily following Buffett’s one-fund idea, but something close to it; “sophisticated investors” may scoff at it, but the ones taking Schwab and Buffett’s lead will not be left behind by the market.

“First you must decide that you want to be an indexer,” said Wiener, “and what Buffett and Schwab are reminding you is that being an indexer means you believe in broad diversification, not trying to time the market or shifting investment strategy or technique to the newest hot thing on the market. If all you are doing is moving from stock-picker to ETF picker, that’s not going to turn out better just because you’re using index funds.”

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